Financial Management – Topic 1: Introduction to Finance and the Financial System

Definition & Scope of Finance

• Finance as a discipline

  • Defined as the science and art of managing money.

  • Operates on two main decision themes:

  • \text{Financing:} How money is raised.

  • \text{Investment:} How money is deployed.

• Personal-finance parallels

  • Individuals decide how much to spend, save, and invest.

  • Central question: allocation between current consumption and future wealth creation.

• Business-finance parallels

  • Firms decide:

  • Capital raising: equity, debt, internal cash flows.

  • Capital allocation: real assets vs. financial assets.

  • Distribution policy: reinvest earnings or return to owners.

Career Opportunities in Finance

• Financial Services (FS)

  • Focus: design & delivery of advice/products to individuals, firms, governments.

  • Typical career paths: banking, personal financial planning, investment management, real estate, insurance.

• Managerial Finance (MF)

  • Focus: duties of the financial manager inside a firm.

  • Range of tasks:

  • Crafting financial plans & budgets.

  • Credit management for customers.

  • Capital-expenditure appraisal (e.g.
    NPV, IRR).

  • Fund-raising to support operations.

  • Environmental pressures that enlarge the role:

  • Global financial crises.

  • Regulatory responses.

  • Intensified global competition.

  • Rapid technological change.

Legal Forms of Business Organisation

• Sole Proprietorship

  • Strengths:

  • Owner receives all profits.

  • \text{Low organisational cost}.

  • Income taxed on owner’s personal return.

  • Independence, secrecy, easy dissolution.

  • Weaknesses:

  • Unlimited liability – all personal wealth at risk.

  • Limited fund-raising power.

  • Requires owner to be "jack-of-all-trades".

  • Difficult to offer long-run career paths.

  • Lacks continuity beyond owner’s life.

• Partnership

  • Strengths:

  • Can raise more funds than proprietorships.

  • Enhanced borrowing power via multiple owners.

  • Access to more brain-power & managerial skill.

  • Income flows through to partners’ personal tax returns.

  • Weaknesses:

  • Partners have joint & several unlimited liability.

  • Dissolves when a partner dies.

  • Liquidation/transfer of interests is hard.

• Corporation

  • Strengths:

  • Limited liability – owners lose only what they invest.

  • Can attain large size by selling \text{stock}.

  • Stock is readily transferable.

  • Perpetual life.

  • Ability to hire professional managers and access capital markets.

  • Weaknesses:

  • \text{Double taxation:} corporate income taxed, dividends taxed (max 15\% in U.S. reference).

  • More expensive to organise.

  • Greater governmental regulation and disclosure; secrecy lost.

• Concept check (True/False)

  • Statement: The sole proprietor’s personal assets cannot be taken to satisfy business debts.

  • Answer: False – unlimited liability means personal assets are at risk.

Goal of the Firm & Business Ethics

• Primary financial goal: Maximise shareholder wealth (i.e. maximise current share price).

  • Managerial decision rule: undertake only those actions expected to increase share price.

• Profit maximisation pitfalls

  • Timing of returns: earlier cash preferred.

  • Accounting vs. cash: reported profit may not equal available cash.

  • Risk: profit measure ignores variability.

• Stakeholder Perspective

  • Stakeholders include employees, customers, suppliers, creditors, owners, community.

  • Objective: preserve (not necessarily maximise) stakeholder well-being – labelled "socially responsible".

• Business Ethics

  • Standards of moral conduct in commerce.

  • Typical violations: creative accounting, earnings management, misleading forecasts, insider trading, fraud, excessive executive pay, options back-dating, bribery, kickbacks.

  • Consequences: negative publicity → litigation → lower share price.

• Ethics programmes aim to

  • Reduce litigation & judgment costs.

  • Maintain positive corporate image.

  • Build shareholder confidence.

  • Gain loyalty/respect from stakeholders.

  • Net effect expected: higher share price.

• Concept check (True/False)

  • \text{(a)} Higher cash flow ↑ → higher share price, higher risk ↑ → lower share price. True.

  • \text{(b)} Managers should accept only actions that increase profitability (not share price). False – focus is share price.

  • \text{(c)} Owners’ wealth = share price. True (for publicly traded stock).

Primary Activities of the Financial Manager

• Organisational context

  • In small firms: finance handled within accounting.

  • In growing firms: separate finance department headed by CFO reporting to CEO.

  • CFO’s domain (see organisational chart): treasury, capital expenditure, credit, cash, foreign exchange, pension fund, tax, cost & financial accounting.

• Core decisions

  • Investment (Capital Budgeting)

  • What real & financial assets to own.

  • Reflected on left side of balance sheet (current & non-current assets).

  • Financing (Capital Structure + Working-Capital Policy)

  • How to raise capital (debt vs. equity, short-term vs. long-term).

  • Reflected on right side of balance sheet (liabilities & equity).

• Balance-sheet categories

  • Assets:

  • Current: cash, inventory, accounts receivable.

  • Non-current: machinery, buildings, vehicles.

  • Financing sources:

  • Current liabilities: accounts payable, dividends payable.

  • Non-current liabilities: bank loans, bonds.

  • Equity: shares (common & preferred).

• Concept check (True/False)

  • \text{(a)} Financial managers emphasise cash flows (not accounting profit). True.

  • \text{(b)} Financing decisions involve left-hand (asset) side of balance sheet. False – financing relates to right-hand side.

Functions of a Financial System

• Money

  • Medium of exchange facilitating trade & specialisation.

  • Solves divisibility problem (enables fractional value exchange).

  • Store of value → allows saving.

• Markets

  • Bring surplus & deficit units together.

  • Determine prices / exchange rates.

  • Surplus units: savers/lenders.

  • Deficit units: borrowers seeking funds.

• Financial Instruments

  • Issued by fund-raisers acknowledging obligation for future cash flows.

  • Solve the "double coincidence of wants" between savers & borrowers.00

• Flow of Funds

  • The movement of money through the system giving rise to instruments and linking institutions/markets.

• Attributes of Financial Assets

  • Return (Yield): \displaystyle \text{Return} = \frac{\text{Total compensation}}{\text{Amount invested}}.

  • Risk: probability actual return deviates from expected return.

  • Liquidity: speed & cost of converting to cash at fair value.

  • Time pattern of cash flows: schedule of expected receipts.

• Additional system roles

  • Portfolio restructuring: allow investors to reshape risk-return-liquidity-timing profile.

  • Monetary policy implementation: central bank actions on interest rates; primary target often inflation.

• Efficiency criteria

  • Encourages saving.

  • Allocates savings to highest-value users.

  • Transmits/implements monetary policy via interest rates.

  • Provides menu of assets/liabilities across return, risk, liquidity, timing dimensions.

• Concept check (True/False)

  • \text{(a)} Money’s attributes include medium of exchange, divisibility & store of value. True.

  • \text{(b)} Financial system comprises institutions, instruments, markets. True.

  • \text{(c)} Efficient systems allocate savings to best users. True.

Review & Exam Connections

• Understand definitions & scope: finance vs. accounting.

• Recall legal forms, their tax, liability, continuity, fund-raising traits.

• Focus on shareholder-wealth maximisation and why profit ≠ value.

• Link ethical behaviour to cost of capital and share price.

• Master investment vs. financing decisions and how each appears on the balance sheet.

• Grasp financial-system functions and how money, markets, instruments interact.

• Be ready for True/False & conceptual exam questions on:

  • Cash flow vs. profit.

  • Unlimited liability.

  • Risk–return–price relationships.

  • Role of ethics in valuation.

Forward Look

• Pre-reading for next lesson: Commercial Banks & Non-Bank Financial Institutions (Chapter 2, Gitman & Zutter, 13^{\text{th}} edition).